GuShiio.com The U.S. debt dilemma cannot be solved for a while, and in the end, it will still have to be handled according to the above two paths of the debt crisis.
This article refers to Dalio’s new book “How Countries Go Bankrupt”, and finally combines my personal views to sort out the opportunities and risks of the U.S. big debt cycle, just as an aid to investment decisions.
Let’s first introduce the founder of Dalio Bridge Water Fund, who has successfully predicted major economic events such as the 2008 financial crisis, the European debt crisis, and Brexit. He is known as the Steve Jobs of the investment community. Let’s enter the main text below.
In the past, when studying debt, it usually referred to the credit cycle that was synchronized with the business cycle (about 6 years and 3 years). The big debt cycle is more important and lower. This is because since 1700, there have been about 750 currencies or debt markets around the world, but only about 20% still exist today. Most of the surviving currencies have experienced severe devaluations, which is closely related to the great debt cycle in the book.
The core difference between a small debt cycle and a large debt cycle lies in whether central banks have the ability to reverse the debt cycle. In the traditional deleveraging process of small debt cycles, central banks will lower interest rates and increase credit supply. But for a large debt cycle, the situation can be very difficult because debt growth is no longer sustainable. A typical path to dealing with a large debt cycle is: private sector health-the private sector over-borrows and is difficult to repay-the government to help, over-borrows-the central bank prints money and purchases government debt to help (the central bank is the borrower of last resort).
The big debt cycle usually lasts about 80 years and is divided into five stages:
1) Sound Money Stage: When interest rates are low initially and the return on borrowing is higher than the cost of capital, debt expands.
2) Debt Bubble Stage: As debt expands and the economy begins to prosper, certain asset prices (stock markets, real estate, etc.) begin to rise. As asset prices rise and the economy continues to prosper, the private sector is more confident in its ability to repay debts and return on assets, so it continues to expand debt.
3) Top Stage: Asset prices have reached bubble stage, but debt expansion has not stopped.
4) Deleveraging Stage: A wave of debt defaults broke out, asset prices plummeted, aggregate demand shrank, and fell into a debt-deflation cycle (Fisher Effect). Nominal interest rates fell to the zero limit. Real interest rates rose due to deflation, and debt repayment pressure intensified.
5) Debt Crisis Stage: As the asset bubble bursts, the debt bubble bursts at the same time. In this case, those who borrow money to purchase assets may not be able to repay their debts. At this time, the entire economy is facing bankruptcy and debt restructuring. This stage also marks the fading of the great debt crisis, a new balance has been reached, and a new cycle has begun.
At each different stage of these five stages, the central bank must adopt different monetary policies to ensure debt and economic stability, so we can also observe the current stage of the big debt cycle through monetary policy.
Currently, the United States has experienced 12.5 short-term debt cycles since 1945. The United States ‘debt interest expenses this year are expected to exceed US$1 trillion, while total government revenue is only US$5 trillion. In other words, for every $4 collected by the U.S. government, it has to spend 1 dollar to pay interest on its debt!
If this trend continues, it will become increasingly difficult for the U.S. government to repay its debts and will eventually be forced to monetize its debts (printing money to pay off its debts), which will further push up inflation and cause serious currency devaluation. Therefore, the United States is currently in the second half of the big debt cycle, that is, on the verge of the Stage 3 bubble burst stage,This means that a debt crisis may be coming。
Below, we review the first long debt cycle experienced by the United States from 1981 to 2000, which is divided into several short cycles.
The first short cycle (1981 – 1989): The second oil crisis that broke out in 1979 caused the United States to enter the era of stagflation 2.0. From February to April 1980, the Bank of America’s best lending rate was raised nine times in a row, from 15.25% to 20.0%. Inflation is at historically high levels and interest rates are also at historically high levels. In order to avoid systemic risks, monetary policy changed from tight to loose. From May to July 1980, the Federal Reserve cut interest rates three times, by 100 BP each time. The interest rate was lowered from 13.0% to 10.0%, for a total of 300 BP. In 1981, after Reagan took office, defense spending was significantly increased. During this period, the government leverage ratio soared. Existing debt expanded rapidly during this period, reaching the highest point of the long debt cycle in 1984, with the deficit accounting for as high as 5.7%. In May, Continental Illinois, the top ten banks in the United States, suffered a run. On the 17th of the same month, the bank accepted temporary financial assistance from the FDIC, which was the most significant bank bankruptcy resolution in FDIC history. In June, the bank’s prime lending rate continued to rise until the Plaza Accord of 1985, which forced the devaluation of the US dollar. After the Plaza Accord was signed, the 1985 Gram-Ludman-Hollins Act was introduced, requiring the federal government to basically achieve a balanced budget by 1991. On October 28, 1985, Federal Reserve Chairman Volcker delivered a speech arguing that the economy needed help from lower interest rates. During this period, the Federal Reserve gradually lowered interest rates from 11.64% to 5.85% in order to re-stimulate the economy.
However, Greenspan, who took office as chairman of the Federal Reserve in 1987, tightened monetary policy again. Rising financing costs led to a decrease in the willingness of companies and residents to raise funds. Interest rate hikes also became an important reason for triggering the Black Monday stock market crash, and economic growth fell further. When Reagan signed the fiscal deficit reduction bill in 1987, the increase in government leverage also began to decline. The increase in leverage ratios of various departments continued to slow down until the end of 1989, and the scale of social leverage entered a sideways stage.
The second short cycle (1989 – 1992): When the Gulf War broke out in August 1990, international oil prices rose sharply, CPI rose to a high since 1983, and GDP growth reached negative growth in 1991. In March 1991, the unemployment rate continued to rise sharply. In order to reverse the dilemma of economic stagflation, the Federal Reserve adopted a loose monetary policy during this period and continuously lowered the federal funds target rate from the cycle high of 9.8125% to 3%. The large amount of fiscal expenditures incurred by launching the war also caused a surge in the leverage ratio of government departments, which triggered an increase in social leverage ratio in 1991. On April 1, 1992, a stock market crash occurred in Japan, and the Nikkei index fell below 17000 points. At this time, it had fallen by 56% from the historical high of 38957 points in early 1990. The stock markets of Japan, the United Kingdom, France, Germany, and Mexico all experienced chain declines due to economic deterioration. In response to the global economic recession, on July 2, the Federal Reserve cut interest rates again by 50BP.
Third short cycle (1992 – 2000): The Clinton administration that came to power in 1992 balanced the fiscal deficit by raising taxes and cutting spending. However, the friendly economic development environment and good economic development expectations after the war enhanced the willingness of residents and the corporate sector to raise funds and promoted the increase in social leverage. Since then, the economy expanded and inflation rose again. The Federal Reserve began to raise interest rates six consecutive times in February 1994, totaling 3 percentage points to 6%. In December 1994, due to the Federal Reserve raising interest rates six consecutive times during the year, As a result, the increase in short-term interest rates significantly exceeded the increase in long-term interest rates, and the bond yield curve turned upside down. From the beginning of 1994 to mid-September, the value of the U.S. bond market lost US$600 billion, and the global bond market lost US$1.5 trillion throughout the year. This is the famous 1994 Bond Crash.
Subsequently, the Asian financial crisis broke out in 1997 and the Russian debt crisis broke out in 1998, which directly led to the collapse of Long-Term Capital Management (LTCM), one of the four major hedge funds in the United States, overnight. On September 23, Merrill Lynch and Morgan Company invested in acquisitions and took over LTCM. In order to prevent financial market fluctuations from hindering U.S. economic growth, the Federal Reserve cut interest rates by 50bps in the third quarter of 1998, Internet companies ‘enthusiasm for development continued to rise, and the increase in leverage ratio in the non-government sector continued to increase. Among them, the increase in corporate leverage reached its highest value since 1986, driving the increase in social leverage ratio upward.
In 2000, the Internet bubble burst and Nasdaq fell 80%. After puncturing the Internet bubble, the increase in leverage and GDP growth in the non-government sector dropped significantly. The increase in social leverage ratio turned negative, the scale of leverage ratio fell. The economic recession and inflation dropped, triggering the next round of credit easing and economic recovery. Since then, this round of debt cycle has come to an end.
After the 2008 financial crisis, the unemployment rate in the United States reached 10%, and global interest rates dropped to 0%. It was no longer possible to stimulate the economy by cutting interest rates. The Federal Reserve launched the largest debt monetization, purchasing debt by printing money. During the 12 years from 2008 to 2020, the United States launched the central bank to expand its balance sheet to purchase bonds, which was essentially money printing, debt monetization and quantitative easing. Then, it began to tighten at the end of the 201st year to fight inflation. U.S. bond interest rates rose and the US dollar strengthened. The Nasdaq index fell 33% from its high point in 2021, while high interest rates also caused losses to the Federal Reserve.
After simply reviewing a debt cycle, it was mentioned earlier that the United States is about to enter the verge of bursting the bubble. The transmission path of the big debt cycle is the private sector-government-Federal Reserve. What will happen when the big debt cycle reaches the central bank?
Step 1: The Federal Reserve expands its balance sheet to monetize debt
When a debt crisis occurs and interest rates cannot be lowered (for example, to 0%), money will be printed and bonds will be purchased. This process began in 2008, which is quantitative easing (QE). Currently, the United States has carried out a total of four rounds of QE, buying a large amount of U.S. Treasury bonds and MBS. The characteristic of QE is that the assets purchased have a relatively long duration, which will forcibly lower the yield of government bonds, encourage money to flow to risky assets, and push up the prices of risky assets.
The money for QE here is realized through reserves (money deposited by commercial banks with the Federal Reserve). When the Federal Reserve goes to buy bonds from banks, it does not need to spend money, but tells banks that the Federal Reserve’s reserves have increased.
Step 2: When interest rates rise, the central bank loses money
The Federal Reserve mainly earns interest income and interest expenses. The structure of its balance sheet is to borrow short and buy long. It must pay interest on short-term assets such as RRP and Reserve, and collect interest on relatively long-term assets such as U.S. bonds and MBS. However, since the interest rate hike in 22 years, the long-term interest rates have been inverted, so the Federal Reserve is losing money. In 23 years, the Federal Reserve lost US$114 bn and in 24 years, it lost US$82 bn.
In the past, when the Federal Reserve made profits, it handed over the profits to the Treasury. When losses occur, this part becomes deferred assets (Earnings Remittances due to the U.S. Treasury), which has accumulated to more than $220 billion.
Step 3: When the central bank’s net assets are significantly negative, it enters a death spiral
If the Fed keeps losing money, it will one day cause its net assets to be significantly negative, which is a real red flag. This marks a death spiral, in which rising interest rates cause creditors to see problems and sell off debt, which in turn leads to further increases in interest rates, which in turn leads to further selling of debt and currency, and the final result is currency devaluation, triggering stagflation or depression.
At this step, the Federal Reserve faces the need to maintain loose policies to support a weak economy and weak fiscal governments on the one hand, and tighten policies (high interest rates) on the other hand to prevent the market from selling money.
Step 4: deleveraging debt restructuring and devaluation
When debt burdens are excessive, large-scale restructuring and/or devaluations occur, significantly reducing the size and value of the debt. At the same time, the currency devalued, and the real purchasing power of the currency and debt holders was severely lost until a new monetary system with sufficient credibility to attract investors and savers to hold the currency again was established. At this stage, the government usually implements extraordinary policies such as extraordinary taxes and capital controls.
Step 5: Establish a new cycle of return to balance
When debt is devalued and the cycle comes to an end, the Federal Reserve may strictly implement the transition from a rapidly devaluing currency to a relatively stable currency by pegging the currency to hard currency (such as gold) when the currency is very tight and the real interest rate is very high. The transition is the establishment of a new cyclical system.
Through the above steps, we can basically judge that the United States is now in the middle of the second step (central bank losses) and the third step (central bank net assets are significantly negative, entering a death spiral). So what is the Fed’s next response?
There are usually two paths to controlling debt. One is financial suppression, which is essentially to lower interest costs. The other option is to control finances, which means to reduce the non-interest deficit. Lowering interest costs means cutting interest rates and alleviating the pressure on interest expenditures. There are only two ways to reduce the non-interest deficit. One is to cut spending, and the other is to increase taxes. These two Trump administrations are already actively promoting it. The DOGE government’s Department of Efficiency reduces government fiscal expenditures and tariff policies increase government revenue.
Despite Trump’s enthusiasm, global financial markets are not so committed to it. Major central banks around the world have long begun to continue to buy gold. Now gold is second only to the US dollar and the euro, and has surpassed the Japanese yen, becoming the world’s third largest reserve currency.
There is a serious problem in the current fiscal situation of the United States. Borrowing new debts to repay old debts, but issuing bonds to fill the fiscal gap, and these new debts in turn bring higher interest expenses, thus plunging the United States into a vicious cycle of debt and eventually may fall into a dilemma where it will never be repaid.
Under such circumstances, the U.S. debt dilemma will not be solved for a while, and in the end, it will still have to be handled according to the above two paths of the debt crisis. Therefore, the Federal Reserve will choose to lower interest costs and relieve the pressure on interest expenditures. Although interest rate cuts cannot fundamentally solve the debt problem, it can indeed temporarily relieve the pressure on some interest payments and give the government more time to cope with the huge debt burden.
The interest rate cut is actually highly consistent with Trump’s U.S. priority policy. The current market consensus believes that Trump’s tariff and fiscal policies after taking office will cause the U.S. deficit to run out of control and lead to a decline in U.S. credit, inflation and interest rates. In fact, the rise in the U.S. dollar is caused by the more decline in market interest rates in other countries relative to the U.S. market interest rates (currency appreciation in countries with relatively high interest rates). The decline in U.S. bond prices (i.e., the rise in yields) is also a normal phenomenon that belongs to a short-term rebound during the interest rate downward cycle.
As for the market’s expected re-inflation, unless Trump breaks out in the fourth oil crisis, based on any logic, it cannot explain his desire to once again push up the level of inflation that Americans most hate.
As for why is the matter of cutting interest rates always difficult to achieve? Since the beginning of this year, expectations for interest rate cuts have been wavering constantly and repeatedly. I think we don’t want interest rate cuts to be overdrawn. Now Eagle can provide space for subsequent cuts.
Looking back on historical experience since 1990, the Federal Reserve suspended interest rate cuts in August 1989 and August 1995 respectively to assess subsequent growth and determine the speed and intensity of interest rate cuts. For example, after precautionary interest rates were cut in July 1995, the Federal Reserve held hold back at three consecutive meetings until the U.S. government closed its doors twice due to failure to reach an agreement on the budget for the new fiscal year. It was not until it decided to cut interest rates by 25bp again in December 1995.
Therefore, you cannot follow the market’s thinking to reason. There will often be problems. You should think differently and do the opposite. So what are the follow-up opportunities?
1. From the perspective of US dollar assets, gold is still a relatively good asset; US bonds, especially long-term bonds, are very poor assets
2. At a certain point in time, the United States will actively or passively start to cut interest rates. We should make calculations and preparations to keep a close eye on the yield of 10-year U.S. bonds.
3. Bitcoin is still a high-quality investment target among risky assets, and the value of Bitcoin is still strong.
4. Once U.S. stocks experience a large-level correction and buy in batches on dips, technology stocks still have a high yield ratio.
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